The Securities and Exchange Commission (SEC) again demonstrated why it and the Federal Reserve Board are the two most-justified federal agencies when, on August 10, 2000, it approved Regulation FD (Fair Disclosure) and additional supporting rules. This signal new regulation, which formally takes effect in November, 2000, bans companies from giving important information, such as earnings revisions, to investment analysts and professional investors before disclosing it to the public.
Regulation FD clearly recognizes the rapidly-changing nature of the investment environment. This environment began changing significantly in 1975 when commissions were deregulated, allowing discount brokers to emerge. It changed even more radically with the development of the Internet, which allows individual investors to engage in online trading, including day trading. Many financial message boards have been created online, resulting in a rapid increase in information available to individual investors, further reducing the advantage of investment professionals.
The new regulation changes the way corporations communicate, reduces the importance of security analysts, increases volatility in the marketplace, and represents a clear victory for Main Street over Wall Street.
Regulation FD addresses the problem of selective disclosure and attempts to clarify existing insider-trading laws. The new rules relate to three issues:
- Selective disclosure by issuers of material non-public information;
- Insider trading liability in connection with a trader’s use or “knowing possession” of material non-public information;
- The breach of a duty of trust or confidence in a family or other non-business relationship that gives rise to liability under the misappropriation theory of insider trading.
The regulation applies only to communications by senior management of a company – including investor relations professionals — who regularly communicate with market professionals and security holders. It applies only to an issuer’s communications with market professionals and holders of the issuer’s securities under circumstances in which it is reasonably foreseeable that the security holders will trade on the basis of the information. The regulation will not apply to issuer communications with the press or rating agencies, or to ordinary-course business communications with customers and suppliers.
The regulation makes it clear that this is a disclosure rule. FD does not create liability for fraud. Only the SEC can bring actions under Regulation FD, thus eliminating private liability for corporations. Further, the SEC has exempted communications made in connection with registered offerings and has made it clear that a violation by a company does not disqualify that company from using short-form registration. Neither does FD disqualify investors from selling under Rule 144. (Rule 144 covers stock issued without a registration statement such as stock owned by an employee.) Finally, FD is not applicable to foreign issuers.
Public Interest and Positive Confidence
The Securities and Exchange Commission was established by Congress in 1934 to regulate the securities markets. Although the Great Crash increased pressure to regulate the markets, attempts to do so date back to the late nineteenth century. Money and capital markets had expanded during the industrial revolution, as had abuses — including the so-called Ponzi scheme where principal was returned to investors as profit. Congress, therefore, passed two key pieces of legislation that set the long-term direction for the regulation of the securities markets: the Securities Act of 1933 and the Securities Exchange Act of 1934. Both laws were part of President Roosevelt’s New Deal legislative package.
The Securities Act of 1933, also known as the “Truth in Securities” law, is specifically designed to regulate the initial sale of virtually all new securities (the primary market). It requires accurate and timely disclosure of information by which potential investors can make informed decisions. The 1934 legislation deals with previously-issued securities (the secondary market). It likewise focuses on accurate disclosure of information and procedures for dealing with listed securities. This act was amended in 1964 to cover most over-the-counter (OTC) securities as well. The major features of these acts include registration of exchanges and brokers, prohibition of misleading trading practices, the establishment of proxy procedures for shareholder votes, and a protocol for handling tender offers.
The passage of these two acts substantially aided the development of the capital markets. The Act of 1933 clearly helped the allocative process, while the 1934 Act improved the operative process. These two acts, along with the SEC itself, gave the United States the potential for developing the most ethical and efficient money and capital markets in the world.
This emphasis on ethical and efficient money and capital markets clearly relates to the ultimate purpose of the regulation of the securities market: the enhancement of the “public interest” and/or the “protection of investors.” “Public Interest” is most often referred to in the context of economic goals, such as growth of capital, the free market place, the matching of savings and investments, and the maintenance of an orderly market.
The regulatory objective of protection of investors is the maintenance of POSITIVE CONFIDENCE in the securities markets. Positive confidence improves overall economic efficiency (both allocative and operative) by providing market liquidity. These vague concepts provide the basis for positive confidence of investors in the money and capital markets. It is the SEC’s responsibility to insure that such positive confidence is present.
The Quarterly Earnings Phenomenon
There is no doubt that long-term securities prices are directly related to long-term growth in earnings or, more appropriately, to long-term growth in cash flow. Yet, the increasing emphasis on short-term gratification in other segments of society has been carried over to emphasizing very short-term holding periods for securities, with a corresponding emphasis on short-term profits. Both academicians and Wall Street professionals believe that this short-term drift in individual firm security prices is due predominantly to two factors: short-term changes in earnings and short-term price momentum.
The U.S. markets require companies to report earnings on a quarterly basis, unlike the rest of the world which reports on a semi-annual basis. The availability of short-term earnings information has given rise to this short-term earnings phenomenon, a pattern that has been building for almost half a century. The concept of SUE (standardized unexpected earnings), which was developed by Henry Latane in the 1960’s, focused on finding companies that statistically outperformed their own linearly-expected quarterly earnings. One purchased (or sold short) stock in those companies that passed (or failed) this test by one standard deviation or more. Others, predominantly Clinton Bidwell, popularized the concept with active investment management. While this is a very mechanical methodology, it worked!
This mechanical method was not lost on the academic community. Many studies were undertaken to test it in hopes of finding an anomaly. One of the more interesting outcomes of these studies was the so-called 20% rule. If a stock had a 20% increase in quarterly earnings above the same quarter a year ago, the stock price sharply advanced. William J. O’Neal and Investors’ Business Daily popularized this thesis.
This half-century’s focus on short-term earnings has pre-conditioned investors and corporations alike. Investors immediately react to new earnings information. Corporations, knowing investors’ preoccupation with these numbers, rely heavily on “managing earnings.” (See “Managing Earnings or Cooking the Books?” by Ferraro and McPeak, Summer 2000, Graziadio Business Review.)
Investment Analysis and the Earnings Game
The rise of the quarterly earnings phenomenon was not lost on Wall Street. Analysts on the Street had a unique position that allowed them a virtual monopoly in the distribution of earnings forecasts. This unique control took on even more significance in the 1960’s when research began to show that stock prices changed disproportionately if — in addition to the above mechanical earnings changes — analysts’ expectations were exceeded. The DREAM stock to purchase was one that reported quarterly earnings with a SUE greater than “one,” had a percentage increase at or above the 20% criterion, and actual quarterly earnings that beat the analysts’ estimates!
This emphasis on quarterly earnings data was noted in the early 1960’s by Samuel Eisenstadt of Value Line. Indeed, the powerful and very successful Value Line Timeliness Rankings incorporates many of the aspects about quarterly earnings noted above.
Wall Street attempted to control the analysts’ estimates through the old Standard and Poor Earnings Forecaster established in the 1950’s. In addition to the security firms themselves, Wall Street sold this information to three key vendors: IBES, Zack’s, and First Call. Individual investors could purchase this information for a reasonable agency cost — initially in print form, and now through the Internet.
The increasing importance, low-cost, and easy availability of these earnings estimates and revisions was again noted by Wall Street. In order to get a higher return, as well as to give professional money managers something more than the public could get, Wall Street developed the more proprietary “Whisper Numbers.” These were also earnings forecasts. They were, however, the REAL earnings forecasts. Wall Street made these “Whisper Numbers” initially available to the professional investment community, but not the general public. Further, earnings revisions were disclosed to certain investment professionals before even the “Whisper Numbers” were revised and released. Most key investment professionals had these “Whisper Number” revisions before IBES, Zack’s, and First Call revised their numbers.
The SEC noted the dissemination of two sets of earnings estimates, as well as the time lag in their disclosure, with great skepticism. It also noted that this near monopoly of earnings forecasts by investment analysts came not from their superior ability to forecast, but from their ability to interface with corporate executives. The simple fact is that no analyst can really forecast the earnings of General Electric, for example. Analysts must be led into a forecast by management. Management must also lead them to changes in that forecast as economic/management conditions evolve.
Regulation Fair Disclosure
This practice of Wall Street being informed first lies at the heart of the new Fair Disclosure Regulation. The ability to have a near-monopoly on information, especially on earnings revisions — even if only for a few hours — allows one to trade with a high probability of financial success. This is due to the fact that once the earnings revision is released, investors will react in a highly-predictable way: Stock prices will move in the expected direction of the revision. The magnitude of the revision will directly impact the magnitude of the price change. With the Fair Disclosure Regulation, the SEC is attempting to insure that ALL investors will have this information set at approximately the same time. Excess profits due to inside knowledge should be eliminated and the Efficient Market Hypothesis supported.
Another result, however, is that the behavior pattern of stock prices should also exhibit increased volatility. This volatility, which will be due to investors’ reactions to new earnings information, will be noted by other investors who are more concerned with short-term price momentum. They, in turn, will react to the changing prices by causing further price changes in that direction. Thus, the regulation will increase market volatility.
Many will complain that the SEC is not doing its job by allowing increased volatility in the markets. This statement is a fair criticism. The SEC, however, has chosen to put a higher priority on the concept of public confidence. Main Street knew the investment professionals were reacting to the information immediately and making a financial gain at their expense. This is why the SEC received more comments on this regulation from Main Street than on any previous regulation. More than one SEC Commissioner stated that he or she was influenced by the clear belief that Wall Street was taking financial advantage of Main Street. The SEC concluded this had a profound impact on public interest by impacting negatively on positive confidence in the fairness of the U.S. securities markets.
The Age of Information is transforming all institutions. This is only one small example of its impact on society. Wall Street, like other institutions, will have to adjust and move forward under the new reality. Indeed, Wall Street has already responded. Over the past few weeks since the SEC approved Regulation FD, there has been less discussion of earnings and earnings revisions. Now analysts are talking about “price targets.” These “price targets” imply an investment strategy. If this information is useful to investors to help them make excess returns, they will have to pay the agency cost to receive it. Wall street and the investment analysts have, perhaps, found a new monopoly of information. It has been noted that securities prices may be affected by analysts’ recommendations even if analysts are (now) using only public information to make them.
The SEC gave a clear victory to Main Street over Wall Street. Wall Street will adjust, as it always has in the past, and move forward. Their earnings information monopoly is gone forever. Money and capital market efficiency has been increased. Public interest and positive confidence have been reinforced. However, a very important aspect of the Investment Game has truly “Gone with the Wind.”
Check out your knowledge of the SEC by trying the Quiz in this issue of GBR.